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Note on Portugal and "Breakup Trade" Scenarios

Monday April 8th 2013

Last Wednesday I was on CNN with Richard Quest and whilst we looked at Slovenia and Malta, I did say that they were little economies...however, even though the Portuguese government had survived a non confidence vote there would be implications for the ability to pass all the required austerity measures.

Portugal is just 1.81% of Eurozone GDP, however, the fact that it may require a second funding bailout should set alarm bells ringing.

Portugal's PSI 20, fell 1.2% at the start of trading.

Portuguese government debt saw the 10 year yield rise to 6.6%, from 6.42% on Friday.

Portuguese Prime Minister Pdro Passos Coelho has led a call for deep reductions in public spending following the rejection of several austerity by the constitutional court. As this happens, from the sidelines the EU are still vocal in warned the Portuguese that they have to respect the agreement and terms of its international bailout.

Now clearly the PM is trying to avoid fiscal mismanagement as Mr Coelho said he was not going to impose new tax increases this year but that measures would be taken to "...contain public spending in the areas of social security, health and education...".

The government has previously stated that it seeks to cut public expenditure by EUR4Bn by 2015.

One will hear all manner of analysis that runs along the lines of "respecting the terms"..."another bailout is unthinkable" etc...etc... however, in a nation where the GDP is roughly 2% agriculture, 23% industry and 75% services the fact that the GDP growth has endured nine consecutive negative quarters with Q4 2012 showing -1.80%. We once again have a situation where the fabric of the Eurozone is proving threadbare. It is the soft underbelly that is the weak spot for the region...look at a map of Europe and it as if the Western / Mediterranean coastline is riddled with "Economic-Quake Epi Centres":

IRELAND

PORTUGALSPAINITALYGREECECYPRUS

One may ask if this places the "Break-Up" trade back on the agenda?

At Spotlight we do not think it ever disappeared...like a boomerang, it keeps coming back. Maybe we call it a "Breakuparrang". The truth is, as we have seen before, the single currency masters are determined not to see the club deminish...we can play the trade but be ready to tack profits quickly, as Portugal will not break the Euro.

The "Break-Up" trade has to scenarios...neither tidy but (A) Orderly (B) Disorderly

(A) Orderly:

Signals given well in advance that in a nation where the government is secure, so making a decision that is not forced by panic but by reasoned consideration parties such as the ECB, EBRD, EU, IMFand IIF can be engaged so that existing debt that has been denominated in Euro can be restructuring with fair but adequate haircuts...organised vis the IIF. If an investor has been driven by yield greed to hold onto risky paper for too long then one can only say "Caveat Emptor".

I would see the new, non-Euro nation having to seek assistance from the IMF as they would be shut out of the international markets for quirte some time ... at least four years, more likely longer and in that sense they would need restructuring via IMF but to overcome the draconian austerity we n]know the IMF demands the nation would need aid from the EBRD, maybe even the World Bank (IBRD).

Given that the nation would now have it own currency back te exchange rate could be used as a safety valve so as to generate a short term competitive angle even though inflation may become a problem...but I see depression which leaving the Euro would avoid as an even worse case to deal with.

Please see paper "Getting Greece To Go"

(B) Disorderly:

Here the situation would be framed by domestic politicians publicly stating they will stay in , "...leaving the Euro is not an option..." we hear that quite frequently. However, as the cost of external aid is applied via austerity so the level of civil disturbance would rise...think of Athens at its worst. (Be prepared to see scenes like that again in May).

Then as the banks really start to creak and when the cash runs out, more aid via a second, third etc bailout would be required. If Greece can have multiple bailouts when it is just 2.5% of Eurozone GDP imagine what a larger nation could demand.

However, as bond yields began to rise so the threat of activating OMT would become a reality...that may contain yields for a while, but I suspect in a real basket case the government would be weak and in a desperate ploy to hold power (the time till the next election would be crucial here) so the respect of bailout and OMT conditionality would vanish.

The banking system would start to collapse...i.e. here would be bank runs and failures, industry and services would wind down on a lack of liquidity. Of under OMT short dated yields may be capped but beyond the OMT threshold the yields would be soaring even though the ECB was under pressure to extend the locus of what it would acquire.

The "Summit Intensity" would rise and yet the markets would see a total failure of policy as political/bureaucratic speaking and thinking became detached from reality.

Then "BOOM!!!"...there would be a simple sovereign bond default...that would probably have happened already...what there would be is a complete collapse in the economy with a risk of anarchy and the rise of political extremes.

That would would rip a hole in Eurozone which is why I ask you to see "Euro's End" because as all the things I describe are happening so other nations would be getting squeezed as well...if one disorderly exit gets to be in motion, then the gravitational laws of the Eurozone will be placed through a financial black hole.

Both scenarios are ugly but the first could be contained...the second would rewrite the books.